Test Bank for Auditing and Assurance Services 7th
Edition
Louwers Blay Sinason Strawser Thibodeau 1259573281
9781259573286
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CHAPTER 10
Finance and Investment Cycle
LEARNING OBJECTIVES
1. Describe the finance and investment cycle, including typical source documents.
2. Identify significant accounts and relevant assertions related to the finance and investment cycle.
3. Discuss the risk of material misstatement in the finance and investment cycle, with a specific focus on improper valuation and disclosure.
4. Identify important internal control activities present in a properly designed system to mitigate the risk of material misstatements for each relevant assertion in the finance and investment cycle.
5. Give examples of tests of controls to test the operating effectiveness of internal 8
controls in the finance and investment cycle.
6. Give examples of substantive procedures in the finance and investment cycle and relate them to assertions about significant account balances at the end of the period.
11, 12, 15, 16, 19, 20, 22 26, 28, 29, 30, 31, 32, 34, 35, 36, 38, 39, 40, 41, 42, 44, 45, 46, 47
49(*), 50(*), 51(*), 52(*), 53(*), 54(*), 55, 56, 57, 58, 59, 60(*), 61(*), 62(*)
7. Apply your knowledge to perform audit procedures in the finance and investment cycle and evaluate the findings of your tests.
(*)Items relates to multiple learning objectives
SOLUTIONS FOR REVIEW CHECKPOINTS
49(*).50(*), 51(*), 52(*), 53(*),60(*), 61(*), 62(*)
10.1 The authorization for investments usually takes place at the highest levels of the organization. An investment philosophy may be stated or endorsed by the board of directors and specific authorization for each transaction may come from the CEO or CFO. Such investments may involve millions of dollars and may be instrumental to the strategic objectives of the organization, commanding the authorization of senior management
10.2 Actions by the board of directors or finance committee are usually required as authorization for notes payable. Auditors would want to read all minutes of the board and executive committees, extracting copies of all financial matters, including notes payable authorizations.
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10.3 Typically, a company will require information from a broker’s advice to correctly account for the initial purchase of an investment security. However, maintaining correct accounting depends on the nature of the investment. For example:
Held to Maturity debt investments may be amortized, which will require appropriate amortization tables
Available for Sale and Trading securities require mark-to-market adjustments, which will require publicly available market values from either a broker or a publication such as The Wall Street Journal.
Equity method investments require obtaining copies of the investees financial statements, as well as records of any dividends received.
Even cost basis investments must be analyzed for potential other-than-temporary declines in value.
10.4 The activities a company performs to reconcile recorded marketable securities depends on whether the client holds the securities. If the securities are held by a brokerage firm, the company may receive periodic statements from the brokerage documenting the securities currently owned. However, if the company holds the securities, the company should perform a periodic securities count that reconciles the name of the company, the interest rate for bonds, the dividend rate for preferred stocks, the due date for bonds, any known serial numbers, and other identifying information. This reconciliation should be performed on a regular basis by a company.
10.5 A compensating control for finance and investment cycle accounts is a control feature used when the company does not specify a standard control procedure (such as strict separation of functional responsibilities). In the area of finance and investment, the compensating control feature is the involvement of two or more persons in each kind of important functional responsibility.
If involvement by multiple persons is not specified, then oversight or review can be substituted. For example, the board of directors can authorize purchase of securities or creation of a partnership. The CFO or CEO can carry out the transactions, have custody of certificates and agreements, manage the partnership or the portfolio of securities, oversee the record keeping, and make the decisions about valuations and accounting (authorizing the journal entries). These are rather normal management activities, and they combine several responsibilities. The compensating control can exist in the form of periodic reports to the board of directors, oversight by the investment committee of the board, and internal audit involvement in making a periodic reconciliation of securities certificates in a portfolio with the amounts and descriptions recorded in the accounts.
10.6 According to auditing standards (AU-C 540, AS 2501) specific relevant aspects of control over the production of accounting estimates include:
Management communication of the need for proper accounting estimates.
Accumulation of relevant, sufficient, and reliable data for estimates.
Preparation of estimates by qualified personnel.
Adequate review and approval by appropriate levels of authority.
Comparison of prior estimates with subsequent results to assess the reliability of the estimation outcomes.
Consideration by management of whether particular accounting estimates are consistent with the company’s operational plans.
10.7 Because transactions in the investing and financing involve large amounts of cash, authorization at the highest levels of governance is critical. Often, this goes all the way to the board of directors. Some transactions which are generally approved by the board include:
Issuance of capital stock
Treasury stock repurchases
Issuance, sale, or purchase of bonds
Large bank loans
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Purchase or sale of buildings and other large assets
Mergers and acquisitions
Dividends
If there is no evidence of approval of these transactions in the board of directors minutes, the auditor should make inquiries to ensure that the transactions were approved.
10.8 When bonds and notes are paid off, they are typically returned to the company. The instruments should then be either marked as paid (canceled), or destroyed. Companies with large bond issuances will often contract with a third party to destroy the bonds. If the bonds or notes are not properly canceled or destroyed, an employee or anyone else who gained custody of the instrument could resell the debt to an unsuspecting investor. Although the note or bond would not be valid, this could still cause a significant headache for the company. Further, an unscrupulous employee with inadequate segregation of duties could potentially pay out a bond for a second time.
10.9 Specific assertions typical of investment account balances are that:
Investment securities are on hand or are held in safekeeping by a trustee.
The accounting for investment cost and market value is appropriate.
Controlling investments are accounted for by the equity method.
Investment income has been received and recorded.
Investments are adequately classified and described in the balance sheet, including disclosures of restrictions, pledges, or liens.
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10.10 Some of the typical areas for concern in the investment accounts are:
Valuation of investments at cost, market, or value impairment that is other than temporary.
Determination of significant influence relationship for equity method investments.
Impairment of goodwill.
Capitalization and continuing valuation of intangibles and deferred charges.
Propriety, effectiveness, and risk disclosure of derivative securities used as a hedge of exposure to changes in fair value (fair value hedge), variability in cash flows (cash flow hedge), or fluctuations in foreign currency.
Determination of the fair value of derivatives and securities, including valuation models and the reasonableness of key assumptions.
Realistic distinctions of research, feasibility, and production milestones for capitalization of software development costs.
Adequate disclosure of restrictions, pledges, or liens related to investment assets.
10.11 Securities held by trustees or brokers should be confirmed, and the confirmation request should seek the same descriptive information as that obtained in a physical inspection by the auditor. That is, the name of the company, number and class of shares, and any restrictions on the stock. The broker can also confirm the market value and the trading activity in the securities for the period.
10.12 As a starting point for auditing fair value estimates, auditors will typically attempt to understand the client’s process for creating the fair value estimate. To this end, auditors can make these inquiries:
Who prepares estimates?
When are they prepared?
What data is used?
Who reviews and approves the estimates?
Have you compared prior estimates with subsequent actual events?
Once an understanding of the estimation process is obtained, auditing fair value measurements is similar to auditing other accounting estimates. Substantive procedures for auditing accounting estimates include determining whether (1) the valuation principles are acceptable under the financial reporting framework, (2) the valuation principles are consistently applied, (3) the valuation principles are supported by the underlying documentation, and (4) the method of estimation and the significant assumptions are properly disclosed according to GAAP
10.13 Some of the typical assertions found in owners’ equity descriptions and account balances are:
• The number of shares shown as issued is in fact issued.
• No other shares (including options, warrants, and the like) have been issued and not recorded or reflected in the accounts and disclosures.
• The accounting is proper for options, warrants, and other stock issue plans, and related disclosures are adequate.
• The valuation of shares issued for noncash consideration is proper in conformity with accounting principles.
• The board of directors has authorized all owners’ equity transactions.
10.14 Some of the important assertions found in the long-term liability accounts are:
• All material long-term liabilities are recorded.
• Liabilities are properly classified according to their current or long-term status. The current portion of long-term debt is properly valued and classified.
• New long-term liabilities and debt extinguishments are properly authorized.
• Terms, conditions, and restrictions relating to noncurrent debt are adequately disclosed.
• Disclosures of maturities for the next five years and the capital and operating lease disclosures are accurate and adequate.
• All important contingencies are either accrued in the accounts or disclosed in footnotes.
• Liabilities are appropriate valued
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10.15 a. Confirmations for stockholder equity: Capital stock may be subject to confirmation when independent registrars and transfer agents are employed. Such agents are responsible for knowing the number of shares authorized and issued and for keeping lists of stockholders’ names. The basic information about capital stock, such as number of shares, classes of stock, preferred dividend rates, conversion terms, dividend payments, shares held in the company name, expiration dates, and terms of warrants and stock dividends and splits, can be confirmed with the independent agents. Many of these items can be corroborated by the auditors’ own inspection and reading of stock certificates, charter authorizations, directors’ minutes, and registration statements. However, when there are no independent agents, most audit evidence is gathered by vouching stock record documents (such as certificate book stubs). When circumstances call for extended procedures, information on outstanding stock (very small, closely held companies) may be confirmed directly with the holders.
b. Notes and bonds payable: Written confirmations are usually obtained from the independent parties. If the notes are payable to banks, the standard bank confirmation may be used. Formal debt instruments can be confirmed by letter to the holder or his or her agent. The confirmation requests should include questions of amount, interest rate, due date, collateral, restrictive covenants, and other terms. To aid in the search for unrecorded liabilities, confirmation requests should be sent to lenders with whom the company has done business in the recent past even if no liability balance is shown at the confirmation date.
10.16 The information that can be confirmed when independent registrars and transfer agents are utilized by the client include the items as features of interest in the answer to review question 10.9. Many of these items can be corroborated by the auditors inspecting the reports from these agents, reading the minutes of the directors, and reading prospectuses.
10.17 Off-balance-sheet information refers to information that relates to obligations and commitments assumed by the clients that do not appear on the balance sheet as current or long-term liabilities. Such information should be disclosed by the client in the footnotes to the financial statements. Therefore, the auditors must be alert to these items and gather evidence that will allow the auditors to determine whether the footnote disclosure is adequate. Such information includes leases, endorsements on discounted notes or others’ obligations, guarantees, repurchase or remarketing agreements, commitments to purchase at fixed prices, commitments to sell at fixed prices, legal judgment, litigation, and pending litigation.
10.18 If a company does not monitor notes payable for due dates and interest payment dates in relation to financial statement dates, these misstatements can appear in the financial statements:
Understated interest expense and understated current liabilities resulting from failure to accrue interest expense.
Understated current liabilities and overstated long-term debt resulting from failure to classify the “current portion of long-term debt” in current liabilities.
10.19 The unfortunate auditors learned that they should know about the requirements of the securities acts, they should use experts in the area if they do not have expertise themselves, and they can ask the SEC for advice in advance.
When suspecting violation of U.S. securities laws (SEC), an auditor should take the factual and descriptive information to a competent attorney for review and an opinion. Auditors can advise company management to consult with the SEC about the necessity for conforming to the law in connection with contemplated transactions.
10.20 Auditors could discover the off-balance-sheet financing described in Case 10.2 (“Off-Balance Sheet Inventory Financing”) by (1) making inquiries about large and unusual financing transactions, (2) noticing the large “sale” transaction when performing analytical comparisons of monthly or seasonal sales, (3) examining the sales contract, (4) discussing with management the business purpose of the transaction, and
(5) inquiring in secretary of state records for identification of customer company incorporators and registered agent.
10.21 Related parties might inflate values with spurious transactions, finally putting them in financial statements of an auditee (“Go for the Gold” case)
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10.22 First, it is essential that the auditors have expertise in the client’s industry. When such expertise is lacking, the auditors must secure the necessary knowledge by hiring knowledgeable personnel or a consultant with the appropriate knowledge. Second, the auditor must take into account the historical nature of films of this type. While management may expect one film to be as successful as recent films of a similar genre, the auditor must take into account the full range of successful and unsuccessful films. A statistical analysis could generate a range of values, which the auditor may use. Within this range, the auditor would likely take a conservative estimate. This may be at odds with management who may want to take a more aggressive approach to the revenue estimate. Third, the auditors must analyze the assumptions used by management to reach their estimates. These assumptions may be based on overly optimistic projection of ticket sales, DVD sales, and other merchandising agreements.
SOLUTIONS FOR MULTIPLE-CHOICE QUESTIONS
10.23 a. Incorrect Because of the large amounts of the items, a substantive approach is preferred.
b. Incorrect Auditors can never ignore internal controls.
c. Correct Controls must be reviewed (and tested for public companies); however, a substantive approach is preferred.
d. Incorrect This would be the least effective approach.
10.24 a. Correct This is the purpose of covenants.
b. Incorrect The covenants are to protect the lender.
c. Incorrect Auditors are not involved in structuring client transactions.
d. Incorrect The board of directors should protect the shareholders from too much debt.
10.25
a. Incorrect This is a related party, but the definition is incomplete.
b. Incorrect This is a related party, but the definition is incomplete.
c. Correct This is the complete definition.
d. Incorrect This is a related party, but the definition is incomplete.
10.26 a. Incorrect This ignores accruals.
b. Incorrect This procedure does not lend itself to statistical sampling because of the low volume of transactions.
c. Incorrect This also ignores dividends receivable.
d. Correct Independent evidence from an outside dividend reporting service is the best evidence for existence, completeness, and valuation.
10.27
a. Incorrect This should be prevented by controls, not the audit.
b. Incorrect See answer (a).
c. Correct The danger is that someone might move securities so the auditor counts them twice.
d. Incorrect This is a danger, but audits cannot be relied upon to detect counterfeit securities.
10.28
a. Incorrect Related parties can own the bonds, but their ownership must be disclosed.
b. Incorrect This is not the responsibility of external auditors.
c. Incorrect This is not a primary responsibility of external auditors.
d. Correct Among the choices available, obtaining an opinion from legal counsel is the best response. The legality of a bond issue is important although not the only important thing.
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10.29
a. Incorrect A company does not necessarily need to use a transfer agent.
b. Incorrect These are usually approved by directors.
c. Incorrect Stock dividends are recorded at fair market value.
d. Correct Capital stock transactions are important by definition, and the directors should have approved all of them.
10.30
a. Incorrect The approximate market value should be shown as the account balance on the balance sheet, not in parentheses.
b. Incorrect The classification of the investment is determined by the maturity or intent, not by the profitability of the investment.
c. Correct Losses on investment should be recorded in the accounts and shown in the financial statements. (Losses on trading securities in the income statement; loss on available-for-sale securities in the equity section.)
d. Incorrect The loss would not be shown separately in the equity section of the balance sheet.
10.31
a. Incorrect This is a substantive test that has little to do with controls.
b. Incorrect Prepaid expense would have to be calculated based on the payment date.
c. Incorrect This might provide evidence regarding imputed interest expense, but only if all liabilities are recorded. Imputed interest generally requires a detailed test considering the specific terms of the debt.
d. Correct “Detect unrecorded liabilities” is the best response, but remember that the procedure might be ineffective if the interest expense on an unrecorded liability is also unrecorded.
10.32 a. Incorrect This is somewhat true because the bank won’t let the auditor in without permission. However, (d) is more important.
b. Incorrect It is unlikely that either would be able to detect forged securities.
c. Incorrect The auditor could do this without the client.
d. Correct A client representative should be present to acknowledge return so the auditor will not be accused of theft.
10.33 a. Correct Stock certificates should be defaced but retained so the auditors can actually see the canceled certificate.
b. Incorrect See (a).
c. Incorrect The defaced certificates should be retained so the auditors can see that they have not been issued.
d. Incorrect See (c)
10.34 a. Incorrect Registrar/transfer agent has no record of restrictions on the payment of dividends.
b. Correct The number of shares issued and outstanding is the record kept by the registrar/transfer agent.
c. Incorrect Registrar/transfer agent has no record of guarantees of preferred stock liquidation value.
d. Incorrect Registrar/transfer agent has no record of the number of shares subject to agreements to repurchase. 10.35 a. Correct Capital stock transactions are important by definition, and the directors should have approved all of them.
b. Incorrect Sales of stock should be traced to cash receipts, but not necessarily other transactions.
c. Incorrect Purchases of treasury stock should be traced to cash disbursements, but not sales.
d. Incorrect If shares are sold, the numbered certificates will not be available.
10.36
a. Incorrect Stock splits have no effect on retained earnings.
b. Incorrect This would not go to beginning balance of retained earnings.
c. Correct These should be authorized by the board of directors.
d. Correct Gain or loss on treasury stock transactions should be audited.
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10.37 a. Correct To conceal fraud related to marketable securities, collusion between those responsible for record keeping and custody would be required. The possibility of collusion is reduced if no direct contact between responsible parties exists.
b. Incorrect Securities must be registered in the name of the company.
c. Incorrect Custody and authorization are incompatible duties.
d. Incorrect How the trust company secures the assets has nothing to do with preventing fraud at the company.
10.38 a. Incorrect This ignores accruals.
b. Incorrect The interest earned depends on the effective rate, not the face rate.
c. Correct The audit program for long-term investments includes making an independent computation of revenue (such as dividends and interest). For example, bond certificates contain information about interest rates, payment dates, issue date, and face amount that the auditor can use to recalculate bond interest earned, including amounts accrued but not collected, during the period the auditee has held the investment.
d. Incorrect See (a)
10.39 a. Incorrect Banks do not open safe deposit boxes.
b. Incorrect Auditors normally do not rely on tests of transactions for securities. The auditor normally needs to count the certificates.
c. Incorrect Banks do not know what is added to or removed from safety deposit boxes.
d. Correct Securities should be inspected simultaneously with the verification of cash and the count of other liquid assets to prevent transfers among asset categories for the purpose of concealing a shortage. If this procedure is not possible but the securities are kept by a custodian in a bank safe deposit box, the client may instruct the custodian that no one is to have access to the securities unless in the presence of the auditor. Thus, when finally inspecting the securities, the auditor may conclude that they represent what was on hand at the balance-sheet date.
10.40 a. Incorrect This is not a suitable objective for analytical procedures because gains and losses can result from unique circumstances.
b. Correct The auditor may develop expectations regarding the completeness assertion for unrecorded investment income from stocks by using dividend records published by standard investment advisory services to recompute dividends received. Interest income from bond investments can be calculated from interest rates and payment dates noted on the certificates. Income from equity-based investments can be estimated from audited financial statements of the investees. Thus, applying an expected rate of return to the net investment amount may be an effective means of estimating total investment income.
c. Incorrect The auditor must evaluate management’s plans for the securities.
d. Incorrect This is not a suitable objective for analytical procedures because market prices are volatile and difficult to predict.
10.41 a. Incorrect If bonds are unrecorded, nothing will show up in bond premium or discount.
b. Incorrect This has nothing to do with completeness of bonds payable.
c. Correct The recorded interest expense should reconcile with the outstanding bonds payable. If interest expense appears excessive relative to the recorded bonds payable, unrecorded long-term liabilities may exist.
d. Incorrect If the payable account is incomplete, the bond will not be on the listing the auditor uses to select confirmations.
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10.42 a. Incorrect
Held-to-maturity debt is recorded at cost.
b. Correct By reconciling interest expense with interest-bearing obligations, the auditor verifies the amount of outstanding liabilities. If interest expense is excessive in relation to the long-term debt, unrecorded interest-bearing obligations may be outstanding.
c. Incorrect The auditor is usually less concerned about existence than completeness.
d. Incorrect If the bond is unrecorded, it will not be in the ledger.
10.43 a. Incorrect This is a management decision.
b. Incorrect This might be a good cash disbursements control, but (d) is more important.
c. Incorrect This is a management decision.
d. Correct Control is enhanced when different persons or departments authorize, record, and maintain custody of assets for a class of transactions. Authorization of notes payable transactions is best done by the board of directors.
10.44 d. Correct Events such as the renewal of the note payable do not require adjustment of the financial statements but may require disclosure. Accordingly, the auditor should determine that the renewal had essentially the same terms and conditions as the recorded debt at year-end. A significant change may affect the presentation of notes payable such as a reclassification from short term to long term.
10.45 a. Incorrect Review of minutes for authorization is an important audit procedure.
b. Correct The registrar would not have information related to the investor or market information.
c. Incorrect The broker in particular would have information on the sale of investments to the client
d. Incorrect Determining market value is an important audit procedure.
10.46 a. Incorrect Review of minutes for authorization is an important audit procedure.
b. Incorrect The registrar would have record of stock sold.
c. Correct Market price is not important in valuing shareholder’s equity.
d. Incorrect Obtaining management representation is an important procedure.
10.47 a. Incorrect There is no evidence that the certificates are forgeries.
b. Correct The main concern is that someone sold the IBM securities (in order to use the cash) and repurchased the securities at a later date. This may have been done for personal use or for the company.
c. Incorrect There is no evidence that the securities are not properly presented on the balance sheet.
d. Incorrect The fact that there is a certificate for IBM stock indicates that the company still owns 100 shares of IBM.
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SOLUTIONS FOR EXERCISES, PROBLEMS, AND SIMULATIONS
10.48 Internal Control Questionnaire for Equity Investments
The three questions in the problem can be called “environment” questions. Questions specific to management assertions are:
Existence or Occurrence
a. Are marketable securities investment transactions supported by invoices from brokers or other documents supporting securities not obtained through brokers?
b. For investments held by the company, are CUSIP numbers recorded for each certificate and are the CUSIP numbers periodically compared to the securities being held?
Completeness
c. Do the cash disbursements procedures contain directions for identifying and accounting for investments in marketable securities?
d. Are subsidiary records of investments kept? Are they reconciled periodically with a control account? Are sales proceeds analyzed to account for gains and losses?
Rights and Obligations
e. Are securities recorded in the company’s name or in broker accounts in the company name?
Valuation or Allocation
f. Are investments representing control over investees accounted for by the equity method?
g. Does the controller approve investment security transactions for proper calculation of interest purchased in bond transactions, special terms of options, warrants, and other features of complicated investment securities?
h. Does the controller’s office receive notice of dividends declared in companies in which investments are held so accounting can match the proper period? Do accountants have instructions to accrue interest to the date of the financial statements?
Presentation and Disclosure
i. Does the board of directors, vice president of finance, or treasurer indicate in writing the intent of the management in connection with classifying investment securities?
a. The objectives (specific assertions) for the audit of investment securities are to obtain evidence regarding the:
Existence of the investment securities at the balance-sheet date
Ownership of the investment securities.
Accurate cost and market value of the investment securities.
Proper classification of the investment securities.
Proper presentation and disclosure of the investment securities in the financial statements.
Proper recognition of interest income.
Proper recognition of investment gains and losses.
b. The following audit procedures should be undertaken with respect to the audit evidence for existence and cost valuation of Bass’s held-to-maturity investment securities:
Inspect and count securities in the company’s safe and safe deposit box.
Examine brokers’ statements to obtain assurance that all transactions were recorded.
Examine documents in support of purchases and sales of investment securities.
Inspect the minutes of the board of directors meetings.
Obtain a client representation letter that confirms the client’s representations concerning the held-to-maturity investment securities.
Verify the calculation of interest income.
Review the propriety of the presentation and disclosure of the securities in the financial statements.
Make certain that the client representation letter includes the proper assertions concerning the securities portfolio.
c. The following audit procedures should be undertaken with respect to the audit evidence regarding Bass’s controlling equity investment in Commercial Industrial, Inc.
Inspect and count securities in the company’s safe and safe deposit box.
Examine documents in support of purchases and sales of investment securities.
Inspect the minutes of the board of directors meetings.
Review the audited financial statements of the (25 percent) investee.
Verify that the equity method of accounting was used for carrying value of the investment in Commercial Industrial.
Obtain a client representation letter that confirms the client’s representations concerning the controlling interest.
Verify the calculation equity method income.
Review the propriety of the presentation and disclosure of the securities in the financial statements.
Make certain that the client representation letter includes the proper assertions concerning the controlling interest.
d. Audit procedures should be undertaken with respect to obtaining audit evidence about the classification of held-to-maturity securities in the Bass portfolio? (Hint: Review the audit program in Appendix 10B-3.)
• Determine the proper classification of securities in the categories of held-to-maturity, available-for-sale, and trading securities.
(a) Inquire about management’s intent regarding classifications.
(b) Study written records of investment strategies.
(c) Review records of past investment activities and transactions.
(d) Review instructions to portfolio managers.
(e) Study minutes of the investment committee of the board of directors.
• Determine whether facts support management’s intent to hold securities to maturity.
(a) Determine the company’s financial position, working capital requirements, results of operations, debt agreements, guarantees, and applicable laws and regulations.
(b) Study the company’s cash flow forecasts.
(c) Obtain written management representations confirming proper classification with regard to intent and ability.
e. Suppose the held-to-maturity portfolio (excluding the investment in Commercial Industrial, Inc.) is carried at cost in the amount of $3,450,000. Audit procedures with respect to obtaining audit evidence about the market (fair) value of this portfolio might include:
• Determine whether the securities are actively traded in a broad market.
• Determine an audit valuation of fair value when appropriate.
(a) Obtain published market quotations.
(b) Obtain market prices from broker-dealers who are market makers in particular securities.
f. Suppose the auditor determines that the held-to-maturity portfolio (excluding the investment in Commercial Industrial, Inc.) has an aggregate market (fair) value of $2,970,000. Audit procedures with respect to obtaining audit evidence regarding a value impairment that might be “other than temporary”? (Hint: Review the audit program in Appendix 10B-3.)
• Determine whether value impairments are “other than temporary” by considering evidence of the following:
(a) Fair value is materially below cost.
(b) The value decline is due to specific adverse conditions.
(c) The value decline is industry or geographically specific.
(d) Management does not have both the intent and ability to hold the security long enough for a reasonable hope of value recovery.
(e) The fair value decline has existed for a long time.
(f) A debt security has been downgraded by a rating agency.
(g) The financial condition of the issuer has deteriorated.
(h) Dividends of interest payments have been reduced or eliminated.
10.50 Lease Accounting. Union Pacific Corp.
a. Union Pacific would prefer accounting for the lease as an operating lease for a number of reasons:
The charge to income for interest and depreciation under capital lease is higher in early years than rent expense charged for an operating lease.
Treating the lease as an operating lease reduces the asset base and improves return on assets.
Treating the lease as an operating lease avoids recording the debt for a capital lease, which results in a lower debt to equity ratio.
b. The auditor would need to review an independent estimate of the value of the building and of its expected useful life. The auditor would also review the terms of the lease for life, renewal options, rental rate, additional rental costs, and so on. The auditor may also want to confirm the terms of the lease with the lessor. Finally, the auditor would test the client’s calculations for the lease treatment under SFAS 13 and obtain representation from the client that the assumptions are appropriate.
10.51 Securities Examination and Count
a. Instructions to be given to the assistant regarding the examination of the securities kept in the safe deposit box include the following:
(1) A copy of the client’s inventory of the contents box should be obtained and used in connection with the inspection of the securities. Comparing the contents of the box and the inventory will provide assurance that all securities listed in the inventory are on hand. (The validity of the inventory will be determined by examination of the transactions pertaining to investments.) The copy of the inventory, after being checked, should be added to the audit documentation as evidence of work performed.
(2) The bank’s record of persons entering the deposit box should be examined to determine that only authorized persons have had access to the box and that there was no entry to the box between December 31 and January 11. Entry to the box between those dates may be an indication that a security was returned to safekeeping after being “borrowed” at year-end. The security may have been “borrowed” and used as collateral to obtain cash to cover a shortage at December 31.
(3) The assistant should be instructed to insist that the treasurer be present while the securities are being examined. The treasurer’s presence will deter any future claim that, if a security is missing at a later date, the assistant took it.
(4) The following details of the securities should be examined:
(a) The name of the registered owner (Demot Corp.) appearing on each security other than bearer bonds should be noted.
(b) The dates stamped on stock certificates giving the dates that the certificates were prepared should be noted and subsequently compared with cash disbursements.
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(c) The name of the corporation issuing the security and the class of the security (Class A, Par Value, 1st Preferred, etc.) should be noted for assurance that a lower priced security (perhaps somewhat similar in corporate name or a different security of the issuing corporation) has not been substituted for a higher priced security.
(d) The face value of bonds and the number of shares represented by each stock certificate should be compared with the inventory to determine that the entire amount of the corporation’s holdings of each security is on hand.
(e) The serial numbers of the securities should be compared with those on the inventory and, for those securities carried over from the prior year, compared with the serial numbers of securities listed in the prior-year audit documentation. A change in serial numbers that cannot be properly explained may be an indication of manipulation of the securities.
(f) The certificate should be read to ascertain that interest rates and payment dates for bonds and the dividend rates and payment dates, if given, for preferred stocks. This information may be used later in the verification of investment income.
(g) Bonds should be examined to determine maturity dates. Maturity dates are needed for checking the computation of the amortization of bond premiums or discounts.
(h) Coupon bonds should be inspected to determine that no past due interest coupons are unclipped and all future interest coupons are attached.
(i) The assistant should be alert for any obvious alterations to securities or forged certificates.
(j) The assistant should also examine the reverse side of the certificates to determine whether they have been endorsed for transfer. The presence of an endorsement may be an indication that the security had been converted temporarily for some use, perhaps fraudulent, in the past.
(k) Any worthless securities on hand should also be examined and compared with the client’s inventory and with prior audit documentation. Any missing securities should be noted for subsequent follow-up to determine that the client had received the funds derived from the sale or redemption of securities deemed worthless in error.
b. The treasurer’s entry into the safe deposit box on January 4 violated the auditor’s control over liquid assets that must be counted simultaneously or kept under control until counted to avoid the substitution of a counted asset for an uncounted asset in an attempt to conceal a shortage. The auditor would probably apply the following additional procedures:
(1) Reconcile bank balances at both year-end and at the count date.
(2) Obtain a bank confirmation as of the count date.
(3) Examine cash entries between year-end and the count date for any unusual entries.
(4) Examine all investment transactions taking place between the balance-sheet date and the count date to verify the amount of the investments at the balance-sheet date.
(5) If the client keeps a large fund of cash on hand, make a surprise count of the cash fund.
(6) Review the transactions since year-end relating to any other assets, such as mortgages owned, to determine whether any substitutions have been made.
(7) Visit the Chamber of Commerce and take a look at the photograph.
10.52 Audit Objectives and Procedures for Investments
1. Investments are properly described and classified in the financial statements.
e. (best) Verify that transfers from the trading portfolio to the held-to-maturity investment portfolio have been properly recorded.
g. (possible) Trace investment transactions to minutes of the board of directors meetings to determine that transactions were properly authorized (especially for the portfolio classification).
2. Recorded investments represent investments actually owned at the balance-sheet date.
f. Obtain positive confirmations as of the balance-sheet date of investments held by independent custodians.
3. Investments are properly valued at the balance-sheet date.
d. Determine whether any other-than-temporary impairments in the carrying value of investments have been properly recorded.
10.53 Intangibles
To transfer cost of improving machinery to the fixed asset account
To record straight-line amortization of patents for the year
b. Inspect the patent document and vouch to the work orders for machinery improvement. Recalculate amortization of patent.
To record unearned revenue in a deferred credit account
b. Vouch transaction to the documentation to support the receipt of revenue. Vouch cash to deposit in bank account.
To record the 60% loss caused by the explosion in the prior year. Correction of an accounting error of the prior year Write-off of damage due to flood.
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b. Vouch to insurance documents for claims. Review local news for evidence of explosion and/or flood.
To record amortization for the year on straight-line basis, 10-year life
b. Recalculate amortization.
To correct the accounting error of last year of improperly capitalizing an expense item
b. Review goodwill account. Vouch to original calculation of goodwill to ensure all expenses in the account are capital expenses.
To record equipment in the proper account and to record a receivable for the real estate taxes
To record current amortization and correct the error of failure to record amortization of leasehold improvements on a straight-line, 10-year basis. No adjustment to depreciation of equipment because it was acquired in December.
b. Vouch transaction to purchase order for equipment and work orders for leasehold improvements. Recalculate amortizations.
To write off organizational expenses improperly capitalized in prior period
b. Vouch transaction to original expenses for proper amounts. Review Retained earnings for propriety of other items.
10.54 Loan Covenants
Note to instructor: Students may wish to reference http://www.loanuniverse.com/covenant.html in responding to this question.
a. Banks usually add covenants to accomplish the following objectives:
Maintain loan quality.
Keep adequate cash flow
Preserve equity.
As a measure to improve the weakness in a borrower with a known weakness in its capital structure.
Keep an updated picture of the borrower’s financial performance and condition
b. Common loan covenants
Things that the borrower must do:
(1) Maintain hazard insurance/content insurance
b. To ensure that if the collateral is damages the company will be reimbursed and can pay off the loan. The borrower is required to keep insurance coverage on the plant/equipment or inventory in order to safeguard against the catastrophic loss of collateral
c. Confirm insurance with the insurance company; review insurance policy at client.
(2) Maintain key-person life insurance
b. To protect the lenders from loses incurred by the loss of a key employee. This insures the life of the indispensable owner or manager without whom the company could not continue. The lender usually gets an assignment of the policy.
c. Confirm insurance with the insurance company; review insurance policy at client
(3) Make all payments of taxes /fees /licenses.
b. To protect the lender from government seizure of property. Borrower agrees to keep those expenses up-to-date as failure to pay would result on the assets of the company being encumbered by a lien from the government, which would take precedence to the one from the bank.
c. Review cancelled checks for payments.
(4) Provide financial information on borrower and guarantor
b. Protect the lender from non-payment due to deteriorating financial condition. Borrower agrees to submit financial statements for the continuing assessment by the bank. Financial statements are usually submitted yearly while account receivable can be required every month.
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c. Review financial information; review financial reports of guarantor (if any); confirm with lender the receipt of financial information.
(5) Maintain a certain level in key financial ratios.
The borrower is required to maintain a certain level in key financial ratios such as:
(a) Minimum quick and current ratios (liquidity)
(b) Minimum Return On Assets And Return On Equity (profitability)
(c) Minimum equity, minimum working capital
(d) Maximum debt to worth (leverage)
b. Financial ratios provide an analysis of the financial condition of the borrower and help the lender determine the likelihood of repayment. In addition, the borrower might be prevented from doing certain things via loan covenants.
c. Review ratios; vouch numbers used in ratio calculations to the source information
(6) Make no change of management or merger without prior approval.
b. Guarantees the continuing existence of your borrower and will impede the deterioration of financial condition due to merger with an unknown entity.
c. Compare organizational charts with prior years; review minutes of the board of directors meetings; review local news sources.
(7) Obtain no more loans without prior approval
b. Ensures that the company does not take on excessive debt affecting the quality of the original loan.
c. Review long term debt accounts and interest expense accounts.
(8) Make no dividends/withdrawals or limited dividend withdrawals
b. In situations in which the net worth is being eroded by the extraction of capital in the form of dividends or stockholder’s withdrawal, the lender might find it necessary to restrict the amount of money that can be taken out of the company. In subchapter-S corporations, it is not uncommon to limit withdrawals to the owner’s tax liability.
c. Review dividend account; review cash disbursements for payments to registrar or to investors.
D. It is important for an auditor to ensure that the client is in compliance with debt covenents because if the client is in violation of the debt covenants the lender may be able to call the debt (i.e. ask for immediate payment). Such a demand for cash, if the amount is large, may create a going concern issue for the client.
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10.55 Long-Term Financing Agreement
a. The procedures you should employ in examining the Broadwall loans are as follows:
Obtain an understanding of the business purpose of the loans made by the president.
Confirm the loans, including terms, by direct communication.
Recompute interest expense and interest payable.
Review minutes of meetings of the board of directors for proper authorization.
Verify payments made during the year and transactions after the year-end.
Read the notes to the financial statements regarding the loan agreements and evaluate the adequacy of disclosure and compliance with restrictions.
Obtain a management representation letter.
b. Broadwall’s financial statements should disclose the following information concerning the loans from its president:
The nature of the related-party relationship.
The dollar amounts of the loans.
Amounts due the president and, if not otherwise apparent, the terms and manner of settlement.
10.56 Bond Indenture Covenants
In each case any actual failure to comply would need to be reported in a footnote to the statements in view of the possible serious consequences of advancing the maturity date of the loan. The individual audit steps follow:
1. Check balance sheets at beginning and through the previous fiscal year for working capital ratio. If under 2:1, check compensation of officers for compliance with limitation.
2. Examine client’s copies of insurance policies or certificates of insurance for compliance with the covenant, preparing schedule of book value, appraised or estimated actual value, and coverage for report. Confirm policies held with trustee.
3. Examine vouchers supporting tax payments on all property covered by the indenture. By reference to the local tax laws and the vouchers, determine that all taxes have been paid before the penalty-free period expired. If vouchers in any case are inadequate, confirm with trustee who holds the tax receipts.
10.57 Common Stock and Treasury Stock: Substantive Audit Procedures
Common Stock Treasury Stock
Existence
(a) Verify authorized shares with reference to corporate charter.
(b) Confirm outstanding shares with owners.
(c) Count outstanding shares as shown in the stock record book stubs.
(a) Inspect the certificates held as treasury stock.
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(d) Verify authorization in board minutes to issue new shares.
(e) Obtain written representations about the number of shares authorized, issued, and outstanding.
Completeness
(f) Reconcile the number of shares: Issued – Treasury = Outstanding Same
Valuation
(g) Vouch amount of paid-in capital to cash receipts.
(b) Vouch amounts recorded for purchase to cash disbursements and amounts received on resale to cash receipts. Recalculate gain (loss) and trace to retained earnings or other capital account.
GAAP disclosure
(h) Read the financial statements and footnotes to determine whether all numbers of shares, terms, and descriptions are accurate.
(c) Read the financial statements, particularly the schedule of capital changes and the footnotes to determine whether the treasury stock amounts (including gains and losses) are properly classified and described.
(i) Vouch stock option and profit-sharing plan disclosures to contracts and plan documents.
10.58 Stockholders’ Equity
a. (1) The audit plan for the examination of Pate Corporation’s Capital Stock account would include the following procedures:
(a) (Presentation and disclosure audit assertions.) Examine the articles of incorporation, the bylaws, and the minutes of the board of directors from the inception of the corporation to determine the provisions or decisions relating to the capital stock such as classes of stock, par value or stated value, authorized number of shares, authorization of the sale of new issues or additional sales of unissued stock, declarations of stock split ups and dividends in the form of cash or stock, and granting of stock options or stock rights.
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(b) (Existence and completeness audit assertions.) Examine the stock certificate stub book and determine whether the total of the open stubs agrees with the Capital Stock account in the general ledger. Examine canceled stock certificates that are generally attached to the corresponding stub. Information on the stubs regarding the number of shares, date, and so on for both outstanding and canceled stock certificates should be compared with the Capital Stock account. All certificate numbers should be accounted for.
(c) (Valuation assertion.) Analyze the Capital Stock account from the corporation’s inception and audit all entries. Trace all transactions involving the transfer of cash either to the cash receipts or the cash disbursements records. If property other than cash was received in exchange for capital stock, trace the recording of the property in the proper asset account and consider the reasonableness of the valuation placed on the property. If the analysis of the Capital Stock account discloses that the corporation has engaged in treasury stock transactions, determine that the increases or decreases in net assets resulting from these transactions have not been placed in the Retained Earnings account.
(2) The audit procedures to be applied to the examination of the Capital Contributed in Excess of Par Value account are usually applied at the same time that the Capital Stock account is being examined because the two accounts are interrelated. The account should be analyzed and the entries audited when the related entries in the Capital Stock account are audited.
(3) The following audit procedures would be applied to the Retained Earnings account:
(a) (Valuation assertion.) Analyze the account from its inception. Consider the validity of the amounts representing income or loss that were closed from the Profit and Loss account.
(b) (Valuation assertion.) Any charges or credits made directly to the Retained Earnings account should be investigated and their treatment reviewed in relation to generally accepted accounting principles.
(c) (Presentation and disclosure assertion.) Actions of the board of directors that affected retained earnings should be traced to the account analysis.
(d) (Presentation and disclosure assertion.) Conditions, such as loan covenants or contingent liabilities, which were uncovered during the audit that might require or make desirable the placing of restrictions on retained earnings, should be brought to the client’s attention, and provision should be made for proper disclosure in the financial statements.
(e) (Valuation objective.) Entries recording cash or stock dividends should be traced to the minutes of the board of directors for authorization and to the Cash account or the Capital Stock account. A separate computation should be made by auditors of the total amount of dividends paid based upon their schedules of outstanding stock as an overall test of the reliability of the distributions. If stock dividends have been distributed, the amount removed from retained earnings should be reviewed for compliance with generally accepted accounting principles.
b. In conducting the audit, the auditors audit retained earnings as they do other items on the balance sheet for several reasons. A principal reason is that this part of the audit is an assurance or double check that no important item was overlooked in the examination of the accounts that were the contra or balancing part of the entry recorded in Retained Earnings. An example of an important item that may be overlooked would be a balance sheet account that was closed during the year under audit and the ledger card for the account removed from the general ledger current file. Another reason is that, although the entry in the contra account may have been examined, the auditors may have overlooked that the balancing part of the entry was to Retained Earnings, a treatment that may have been contrary to generally accepted accounting principles; their examination of retained earnings would bring this noncompliance to their attention.
10.59 Intercompany and Interpersonal Investment Relations
This case is intended to evoke discussion of significant controlling interests in investments.
a. The issues revolve around
(1) Conflicts of interest. Students should recognize the apparent existence of non-arm’slength transactions in the transfer prices of products to Hardy Hardware from Hardy Products. However, whether the prices are not equivalent to market prices is not certain. Hardy Hardware may outperform the rest of the industry for other reasons, and Hardy Products’ net of 1 percent on sales may be characteristic of its business (although the 1 percent is extremely low). The brothers have no apparent conflict between themselves. Any conflict would have to be perceived as being between the brothers and the public shareholders.
(2) The criterion presumption for using the equity method is a 20 percent stock ownership, and Hardy Hardware’s ownership amounts to only 15 percent. However, other controlling influences are at work, namely, James Hardy’s effective control of Hardy Hardware (20 percent) and his consequent ability to dictate the voting of the 15 percent interest in Hardy Products.
b. Some might say that this interrelationship of investments constitutes a significant controlling influence that, although not vested entirely in the investor corporation (Hardy Hardware), certainly operates to the benefit of Hardy Hardware. Whether to insist on the equity method in this case represents a difficult decision as the former auditor apparently found out.
c. The auditor should seek to compare the transfer prices to market-determined prices for the same or similar goods. The possibility exists that Hardy Products is charging break-even prices to that Hardy Hardware can show better operating results.
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d. Adequate disclosure in this case is not an easy issue. Certain SEC rules require disclosure of transactions with controlling persons. Hardy Hardware will certainly have to observe SEC regulations in statements filed with the Commission, and the auditor might protect herself or himself as well as serve the public shareholders by insisting on similar disclosures in the annual report. The “related-party transaction” disclosures specified in FASB statements and auditing standards would be appropriate.
10.60 Related-Party Transaction “Goodwill”
Audit Approach
Objective: Obtain evidence of the valuation of assets given in exchange for stock and notes to find the proper valuation of recorded goodwill.
Control: Control rests with the management and accounting estimates of the value of the assets given in exchange. Estimates of this type should be made with faithfulness to the underlying nature of the assets and their proper valuation.
Tests of Controls: Auditors should determine the extent of management involvement in major investment and disposal transactions. Studying the minutes of the board and internal correspondence can help contribute this information. All other procedures bear directly on the substantive valuation evidence.
Audit of balance: Because the Amron stock asset valuation was based on the transfer of the ammunition business assets to the new corporation, the underlying composition and book value of the assets should be determined in detail. This work should reveal that the Amron’s stock carrying value included the deferred cost amount of $7 million. The hard part is discerning that the business purpose of the transactions is to get out of the sporting ammunition manufacturing business. If the auditors concentrate on the flow of the transaction and don’t get the big picture, they might miss the event of discontinuance.
The Big Industrial-Gulwest transaction appears to be clear. Gulwest received stock and a note with total value of $5.4 million. Piercing the veil of the intervening corporate creation transactions and transfers, Gulwest gave assets that were on its original books at $12.4 million.
Discovery Summary
The evidence of value received and cost given indicated a loss of $7 million. Auditors may need to be perceptive and a bit clever to identify it directly with the discontinued line of business, or even to call it “discontinued.” Nevertheless, they were able to identify the amount as a loss and force its recognition in the Gulwest income statement. The spurious “goodwill” was removed from the Gulwest balance sheet.
10.61 Related-Party Transaction Valuation
Audit Approach Objective: Obtain evidence to determine the proper valuation of asset exchanges involving noncash property.
Audit of balances: Upon knowing the date of the transaction purchasing the airplane from Wing and the number of Wing shares transferred, the auditors can look up the quoted market price in newspapers or other library sources for market price history. Finding the market price should determine the proper amount to record for the airplane.
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Auditors should have a list of all subsidiary companies and should be able to recognize the Mexican subsidiary as a related party. With this relationship, the amount of the transaction price is suspect. However, efforts can be made to obtain new and used airplane prices to determine whether the $3,750,000 price to the Mexican subsidiary bore any relation to observable airplane valuations.
If the value were $3,750,000, the “gain” exists in the transaction with the subsidiary, subject to elimination in consolidation. This “gain,” if any, should not be offset against the loss from the exchange with Wing.
Discovery Summary
The auditors were astute. They found that the market value of the Wing stock was $2,520,000 and insisted that the airplane be valued at $3 million instead of $3,750,000, thus making the loss on the exchange of Wing stock $750,000 larger. They also made sure that the subsequent gain on the sale to the Mexican subsidiary was eliminated in consolidation, awaiting any future profit confirmation by a sale to an outside party.
10.62 Lack of Controls over Investments AUDIT APPROACH
Objective: To obtain evidence that trades recorded are valid and authorized (existence or occurrence assertion).
Control: Several controls were missing at Baring Group.
Leeson should have had a clear reporting line to a person of authority. Due to a reorganization, the two groups that might have had responsibility each thought he was reporting to the other one.
Long and short positions should always be balanced. Leeson could be unbalanced during the day but was supposed to be balanced at the end of each day.
Trading limits should have been strictly enforced. Because Leeson appeared to be profitable, trades of amounts over his limits were overlooked.
The Credit Control department should have approved “loans to clients,” which Leeson used to hide losses.
Internal audit reports should be followed up on
Reconciliations of funds remitted to trades made should have been completed and balanced daily.
Tests of controls: Auditors should:
Obtain large trades and examine them for proper authorization.
Examine reconciliations and Barings’s follow up of unreconciled items.
Ask for follow-up reports related to internal audit findings.
Compare trades to authorization limits.
Examine “loans to clients” for credit authorization.
Audit of balances: The auditors should confirm the large balances in the “loans to clients” account. They should also examine the details of account 88888 for authorization of transactions.
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Discovery Summary
In January 1995, The Singapore International Monetary Exchange (SIMEX) queried Baring on the size of their positions on the exchange. SIMEX specifically questioned irregularities in the margining of account 88888. Baring responded in a letter assuring SIMEX of the adequacy of funds to support the positions and made it clear that the entire assets of Baring Group were available to meet its financial obligations to SIMEX. Also in January 1995, Coopers & Lybrand, Singapore discovered a discrepancy of ¥7.7 billion between SIMEX and Baring accounts. Within a few days, six different versions of how the receivable had arisen were circulated among Baring senior management. On February 23, Leeson went missing. The liabilities he left behind totaled $1.3 billion more than the entire capital and reserves of Baring. He was arrested in March in a German airport. On December 2, a Singapore court sentenced him to six and a half years. “I don’t think of myself as a criminal,” Leeson said before his trial.
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